Understanding ESOP Valuation for Unlisted Companies in India

Employee Stock Option Plans (ESOPs) are a powerful tool for unlisted companies in India to attract, retain, and motivate talent, particularly in startups and growth-stage firms. However, valuing ESOPs in unlisted companies is complex due to the absence of a public market price and stringent regulatory requirements. Whether you’re an employee holding ESOPs, an HR professional designing a scheme, or a business owner exploring equity-based incentives, understanding the valuation process and compliance obligations is crucial. 

This guide provides a comprehensive overview of ESOPs, their importance, issuance process, valuation methods, taxation, and more, tailored to the Indian context.

What is an Employee Stock Option Plan (ESOP)?

An Employee Stock Option Plan (ESOP) is a benefit scheme where a company grants employees the right to purchase its shares at a predetermined exercise price after a specified vesting period. Unlike listed companies, where share prices are determined by the stock market, unlisted companies rely on professional valuation to estimate the fair market value (FMV) of their shares. ESOPs align employee interests with company growth, offering potential financial gains if the company performs well.

For example, an employee might be granted 1,000 options at an exercise price of ₹10 per share, vesting over four years. If the FMV rises to ₹50 at exercise, the employee can buy the shares at ₹10 and potentially sell them later at a higher value during a liquidity event, such as an IPO or acquisition.

Importance of the Employee Stock Option Plan 

ESOPs are particularly valuable for unlisted companies, especially startups, due to their ability to incentivize employees without straining cash reserves. Key benefits include:

• Fosters Long-Term Commitment: ESOPs typically vest over 3-5 years, encouraging employees to stay with the company to realize the benefits of their options. This reduces turnover and builds loyalty.
• Attracts Talent for Startups: Startups with limited funds can use ESOPs to attract skilled professionals by offering a stake in future growth, compensating for lower salaries.
• Capital Conservation: By offering equity instead of cash, companies preserve capital for operational and growth needs.
• Employee Motivation: ESOPs provide a sense of ownership, motivating employees to work toward achieving the company’s goals, as their financial rewards are tied to its success.

Benefits of ESOPs in Unlisted Companies

For Employers

• Talent Retention: ESOPs incentivize employees to stay long-term, reducing recruitment costs.
• Cost-Effective Compensation: Equity-based incentives minimize cash outflows, crucial for cash-strapped startups.
• Alignment of Interests: Employees become stakeholders, driving performance and innovation.

For Employees

• Potential Financial Gains: If the company’s value increases, employees can profit by exercising options at a lower price and selling shares later at a higher value.
• Sense of Ownership: ESOPs foster a culture of shared success, enhancing job satisfaction.
• Career Incentive: Employees are motivated to contribute to the company’s growth, as their efforts directly impact their rewards.

Challenges and Risks of ESOPs in Unlisted Companies

While ESOPs offer significant benefits, they come with challenges and risks:

• Complex Regulatory Compliance: Issuing and valuing ESOPs involves navigating the Companies Act, 2013, and Income Tax Act, 1961, requiring approvals, filings, and professional valuations.
• Limited Share Liquidity: Unlike listed shares, ESOP shares in unlisted companies are illiquid, making it difficult for employees to sell them without a liquidity event (e.g., IPO, buyback, or acquisition).
• Valuation Complexity: Determining the FMV of unlisted shares is intricate, requiring registered valuers and merchant bankers, and is subject to regulatory scrutiny.
• Financial Risk for Employees: The value of ESOPs depends on the company’s performance. If the company underperforms, options may become worthless.
• Tax Implications: ESOPs are taxed at exercise (as a perquisite) and sale (as capital gains), which can reduce net gains for employees.

Eligibility Criteria of the Employee Stock Option Plan in an Unlisted Company

Under the Companies (Share Capital and Debentures) Rules, 2014, the following are eligible for ESOPs in unlisted companies:

• Permanent Employees: Full-time employees (Indian or foreign) of the company, its parent, or subsidiary.
• Directors: Whole-time or part-time directors, excluding independent directors.
• Exclusions:
  • Promoters or employees belonging to the promoter group.
  • Directors (or their relatives/body corporates) holding more than 10% of the company’s equity shares, directly or indirectly.
  • Independent directors.

Startup Exemption: Companies registered under the Startup India Initiative (with annual turnover < ₹100 crore and focus on innovation) are exempt from the promoter and >10% director restrictions for 10 years from incorporation.

For private companies, the Articles of Association (AoA) must authorize ESOP issuance. If not, an Extraordinary General Meeting (EGM) is required to amend the AoA, followed by a board resolution and shareholder approval via a special resolution.

Process of Issuing ESOPs in Unlisted Companies

Issuing ESOPs in unlisted companies involves a structured process to ensure compliance with the Companies Act, 2013. The steps are:

• Designing the ESOP Scheme:
  • The board of directors approves a comprehensive ESOP scheme, detailing:
    • Total number of options to be granted.
    • Eligibility criteria for employees.
    • Vesting period (minimum one year between grant and vesting, known as the cliff period).
    • Exercise price and period.
    • Lock-in period (if any).
    • Conditions for forfeiture (e.g., employee resignation).
    • Valuation method for options.
  • The scheme must comply with accounting standards (Ind AS 102).
• Shareholder Approval:
  • A special resolution is passed at a general meeting, covering:
    • Eligibility criteria.
    • Number of options.
    • Vesting and exercise terms.
    • Maximum options per employee.
    • Compliance with applicable regulations.
  • For options granted to parent/subsidiary employees or options ≥1% of issued capital to specific employees in a year, a separate special resolution is required.
• Filing Form MGT-14:
  • The special resolution is filed with the Registrar of Companies (RoC) within 30 days using Form MGT-14.
• Maintaining Records:
  • A register of ESOPs is maintained in Form SH-6, recording details of options granted, vested, and exercised.
• Ensuring Compliance:
  • The company discloses ESOP details in the Director’s Report and files forms like PAS-3 with the RoC upon exercise of options.

Example: A startup designs an ESOP scheme granting 10,000 options to employees, vesting over four years (25% annually) at an exercise price of ₹20. The scheme is approved by shareholders, filed with the RoC, and recorded in Form SH-6. Upon exercise, the company files PAS-3 and updates its records.

Valuation of ESOPs in Unlisted Companies

Valuing ESOPs in unlisted companies is a critical process governed by the Companies (Share Capital and Debentures) Rules, 2014, and the Income Tax Act, 1961. Unlike listed companies, unlisted firms lack a market price, necessitating professional valuation to determine the fair market value (FMV) of shares.

Regulatory Requirements

• At Grant: A registered valuer, approved by the Insolvency and Bankruptcy Board of India, determines the FMV of shares as per Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014.
• At Exercise: A merchant banker provides a valuation report for tax purposes under Section 17(2) of the Income Tax Act, 1961, and Rule 11UA of the Income Tax Rules, 1962.
• The valuation must comply with prescribed methodologies and be documented for regulatory scrutiny.

Common Valuation Methods

• Discounted Cash Flow (DCF):
  • Estimates the present value of the company’s future cash flows, discounted using the Weighted Average Cost of Capital (WACC).
  • Suitable for companies with predictable cash flows.
  • Example: A company projects ₹10 crore in cash flows over five years, discounted at 12% WACC, yielding an FMV of ₹6 crore.
• Asset-Based Approach:
  • Sums the value of tangible (e.g., property, equipment) and intangible (e.g., patents, goodwill) assets, minus liabilities.
  • Useful for asset-heavy companies but may undervalue growth potential.
• Comparable Company Analysis (CCA):
  • Compares financial metrics (e.g., revenue, EBITDA) of similar companies in the same industry.
  • Adjusts for size, growth, and risk to estimate FMV.
• Option Pricing Models:
  • Models like Black-Scholes or Binomial value the options themselves, factoring in share price volatility, time to exercise, and risk-free rate.
  • Commonly used for ESOP accounting under Ind AS 102.

Example: A registered valuer uses DCF to estimate an unlisted company’s FMV at ₹100 per share at grant. At exercise, a merchant banker confirms the FMV at ₹150, used for perquisite tax calculation.

Taxation of ESOPs

ESOPs in India are taxed at two stages under the Income Tax Act, 1961:

• At Exercise (Perquisite Tax):
  • The difference between the FMV (determined by a merchant banker) and the exercise price is taxed as a perquisite under Section 17(2).
  • This amount is added to the employee’s salary income and subject to income tax at slab rates.
  • Employers deduct TDS and report the perquisite in Form 16.
  • Example: An employee exercises 1,000 options at ₹20 when FMV is ₹50. The perquisite is (₹50 – ₹20) × 1,000 = ₹30,000, taxed at the employee’s slab rate (e.g., 30% = ₹9,000 tax).
    
• At Sale (Capital Gains):
  • The difference between the sale price and FMV at exercise is taxed as capital gains.
  • Short-Term Capital Gains (STCG) apply if shares are held <12 months (taxed at 15%).
  • Long-Term Capital Gains (LTCG) apply if held ≥12 months (taxed at 10% above ₹1 lakh).
  • Example: The employee sells the shares at ₹70 after 18 months. LTCG is (₹70 – ₹50) × 1,000 = ₹20,000, taxed at 10% (₹2,000 if within ₹1 lakh exemption).

Accounting for ESOPs

Under Ind AS 102 (Share-Based Payments), unlisted companies must recognize ESOP expenses in their financial statements based on the fair value of options at grant, typically calculated using models like Black-Scholes. The expense is amortized over the vesting period, impacting the profit and loss statement. For example, if 10,000 options are granted with a fair value of ₹30 each, vesting over four years, the company recognizes ₹75,000 (10,000 × ₹30 ÷ 4) annually as an expense.

Realizing ESOP Gains in Unlisted Companies

ESOP shares in unlisted companies are illiquid, posing challenges for employees seeking to realize gains. Common exit options include:

• Company Buyback: The company repurchases shares at FMV, subject to approval under the Companies Act, 2013.
• Liquidity Events: Shares are sold during an IPO, acquisition, or private sale to investors.
• Secondary Markets: Rare in India, but employees may sell shares to private buyers with company approval.
• Example: An employee exercises 1,000 options at ₹20 (FMV ₹50) and holds the shares. During an acquisition, the shares are sold at ₹80, yielding a pre-tax gain of ₹60,000 (₹80 – ₹20 × 1,000).

Reporting and Compliance Obligations

Unlisted companies must adhere to strict reporting and compliance requirements for ESOPs:

• Maintain ESOP Register: Record details of options granted, vested, and exercised in Form SH-6.
• File Forms with RoC: File Form MGT-14 (within 30 days of resolution) and PAS-3 (upon exercise).
• Disclosures in Director’s Report: Detail the number of options granted, vesting period, exercises, and scheme changes.
• Tax Compliance: Deduct and deposit TDS on perquisite tax and report in Form 16.
• Accounting Compliance: Adhere to Ind AS 102 for expense recognition.

Conclusion

Employee Stock Option Plans (ESOPs) are a win-win for unlisted companies and their employees in India. For companies, particularly startups, ESOPs attract and retain talent, conserve cash, and align employee efforts with growth objectives. For employees, ESOPs offer a stake in the company’s future success, fostering motivation and financial rewards. 

However, the complexity of valuation, taxation, and compliance requires careful planning and professional expertise. By adhering to the Companies Act, 2013, Income Tax Act, 1961, and engaging registered valuers and merchant bankers, unlisted companies can implement ESOPs effectively, driving long-term value for all stakeholders. 

Frequently Asked Questions on ESOP Valuation for Unlisted Companies in India

Q1. Can an unlisted company issue ESOPs in India?

Ans1. Yes, unlisted companies can issue ESOPs under the Companies Act, 2013, and the Companies (Share Capital and Debentures) Rules, 2014, by obtaining shareholder approval and complying with valuation and reporting requirements.

Q2. How is ESOP valuation conducted for unlisted companies?

Ans2. A registered valuer determines the FMV of shares at grant using methods like DCF, asset-based, or comparable company analysis. At exercise, a merchant banker provides a valuation for tax purposes, as per the Income Tax Act, 1961.

Q3. What are the tax implications of ESOPs?

Ans3. ESOPs are taxed at exercise as a perquisite (FMV minus exercise price, added to salary income) and at sale as capital gains (sale price minus FMV, taxed at 15% for STCG or 10% for LTCG above ₹1 lakh).

Q4. What is the minimum vesting period for ESOPs?

Ans4. The minimum vesting period is one year between grant and vesting, as per the Companies (Share Capital and Debentures) Rules, 2014.

Q5. How can employees sell ESOP shares in unlisted companies?

Ans5. Employees can sell shares during a company buyback, IPO, acquisition, or private sale (with company approval). Shares are illiquid otherwise, as there is no public market.

Q6. Who is eligible for ESOPs in unlisted companies?

Ans6. Permanent employees and directors (excluding independent directors, promoters, and those holding >10% equity) are eligible, with exemptions for startups under the Startup India Initiative.

Q7. What valuation methods are used for ESOPs?

Ans7. Common methods include Discounted Cash Flow (DCF), Asset-Based Approach, Comparable Company Analysis, and option pricing models like Black-Scholes.

Q8. Are ESOPs included in Cost to Company (CTC)?

Ans8.: ESOPs are typically not included in CTC, as their value is speculative and realized only upon exercise and sale. However, companies may highlight ESOPs as part of compensation packages.

Q9. What is the role of a merchant banker in ESOP valuation?

Ans9. A merchant banker provides a valuation report at the exercise stage for tax purposes, as mandated by the Income Tax Act, 1961, ensuring compliance with Rule 11UA.

Q10. How do unlisted companies account for ESOPs?

Ans10. Under Ind AS 102, companies recognize ESOP expenses based on the fair value of options at grant, amortized over the vesting period, using models like Black-Scholes.